I’ve had a lot of questions about NGDP futures targeting, and so I thought I should do a post answering some of those questions. My preferred target is a 5% NGDP growth trajectory (aka level targeting) but to keep the discussion manageable I’d like to put off practical questions about which target, which time period, levels vs growth rates, etc. Let’s just focus on the core concept. Will it work? By “work,” I mean would it have prevented the crash of 2008? I say yes.

For simplicity, let’s assume that the central bank decides on a 3.65% NGDP growth path. To respond to David Glasner’s concerns that we first need to catch up to trend, we will set the first NGDP target 6% above current estimated NGDP. Each day, the target for NGDP is raised one basis point. Assume the policy begins on May 16, on which day the Fed estimates NGDP to be $15 trillion. Then they would set the NGDP target for May 16, 2010 at $15.9 trillion, 6% above current estimated levels. Each day they raise their NGDP target by one basis point. From now until forever. Thus the target NGDP for May 17, 2010 is $15, 901,590,000 and zero cents.

At this point you may be scratching your head and wondering what I mean by daily NGDP estimates. Right now U.S. GDP is calculated quarterly. I assume that the government could come up with monthly NGDP estimates (doesn’t Canada do this?) And it’s obvious they could use monthly estimates for other potential targets such as the CPI or a nominal wage index. However, nothing really crucial hinges on that assumption; it just makes the plan easier to explain.

But how do we get daily estimates? Simply take a weighted average of two consecutive monthly announcements. Thus the May 31, 2010 NGDP estimate is assumed to be an average of the May and June 2010 NGDP announcements. For the May 21, 2010 estimate, it would be about 5/6 times the May 2010 NGDP announcement, plus 1/6 times the June 2010 announcement. I don’t know if these numbers are exactly right, but I think you get the idea. Note that it is not particularly important that the actual future GDP is equal to these futures estimates, just that we have a reasonable way of determining the payoff for future NGDP contracts. Also assume that at maturity the contracts are worth 1/1,000,000,000,000th of nominal GDP, roughly $15.90.

Now let’s assume that it’s May 16, 2009 and the Fed begins targeting the price of futures contracts due on May 16, 2010, at a price of $15.90. The Fed agrees to buy and sell unlimited quantities of these contracts at the target price. This guarantees that the market price of the contract is always precisely equal to the Fed’s NGDP target. Each buyer must put 10% into some sort of margin account. The Fed pays interest on these margin accounts. How much interest? Enough to assure that these policy futures markets are highly liquid. So liquidity is also not a problem. The contracts are settled about 14 months later, after all the relevant GDP data has been announced.

Before the start of trading, the Fed sets the monetary base at the level that they believe will lead to an expected future NGDP of $15.9 trillion. Once they open the futures market for trading, they announce that each $100 purchase of NGDP futures will trigger a Fed open market sale of $500, presumably of short term T-securities. I don’t believe the Fed would need to buy any other assets, but if they did, then they could buy TIPS, longer maturity T-notes and bonds, high quality foreign government debt, U.S. agency debt, foreign agency debt, high quality corporate bonds, in that order (although I have an open mind on this question.)

Trading would continue until the market reached equilibrium. This would occur when the monetary base had settled at a level where there was no longer any demand for trades. I think it is important to distinguish between how this market would operate during ongoing operation, and when it is initially set up. Under normal conditions the demand for base money is relatively predictable from day to day. There are trend, seasonal, and day of the week fluctuations in the demand for base money, all relatively predictable. Thus as a practical matter the Fed would rarely take a significant net long or short position on NGDP futures. Even more importantly, as long as their forecasts of base demand were unbiased, the net short and long positions from one day to the next would be entirely uncorrelated. Because actual future daily NGDP estimates would be (by construction) highly serially correlated, this means the Fed would take on relatively little risk over time.

On the day the program was first launched there might be somewhat greater uncertainty regarding the demand for base money. That is because the demand would be contingent on the program being in operation. And this problem could be especially severe in a liquidity trap. In my view, this problem could be mostly eliminated through a penalty rate on excess reserves. Such a policy would make the demand for base money much more predictable, as currency would then make up about 90% of base demand, and currency demand changes relatively slowly

Once the program was in operation, there would be several potential weaknesses:

1. Even if the program stabilized 12 month forward NGDP expectations, it might not stabilize longer term NGDP expectations if the public expected the Fed to abandon the policy at some point in the future. However, I don’t see this as a major drawback, as I believe stabilizing 12 month forward NGDP expectations would keep nominal wage rates well behaved, and (like Earl Thompson) I regard aggregate nominal wage instability as the key factor behind macroeconomic instability. Furthermore, the Fed could also trade longer term NGDP contracts, not as a way of affecting the base, but rather of overcoming the time inconsistency problem by setting itself up for future losses should it abandon the policy.

2. The price of the contract may not be equal to the optimal forecast of next year’s NGDP. This is actually two separate problems:

a. The price of NGDP contracts may not equal the market forecast of next year’s NGDP.

b. The market forecast of next year’s NGDP may not be the optimal forecast.

Of course the first discrepancy is simply the risk premium, while the second is the deviation from the rational expectation forecast.

Hartzmark (1987, JPE) found no evidence of risk premia in commodity futures markets. But even the finding of no risk premium in commodity futures markets grossly overstates the size of the risk premia problem in an NGDP futures market, for three reasons:

1. Risk premia often exist because traders want to hedge against risk of price changes. However, unlike for commodities, there is no significant NGDP futures market today. This suggests relatively little demand to hedge NGDP risk.

2. NGDP is much less volatile than most commodity prices.

3. Only the time-varying part of NGDP risk premia would cause macroeconomic problems, except at the date of adoption.

Some people draw false analogies with the TIPS market. The TIPS/conventional bond yield spread may sometimes be distorted by shifts in liquidity preference. This is a problem because TIPS are not pure inflation plays, but rather close substitutes for conventional bonds which trade in a somewhat more liquid market. NGDP futures should not be attached to any sort of bond.

I won’t spend much time on the rational expectations debate. You probably know I am a big believer in Ratex, and the “wisdom of crowds” in general. When I began this project in the 1980s I used an “archipelago model,” where each person observed local shocks before the Fed. And all of those individual observations were aggregated by the futures market. But as we will see, the real advantages of futures targeting lie elsewhere.

In a more recent paper with Aaron Jackson in Economic Inquiry (2006), we showed that futures targeting would eliminate the need for the central bank to estimate a structural model of the economy. This is a big advantage, as there is no general agreement among macroeconomists as to which structural model is best. In a BEJ Contributions to Macroeconomics paper (2006), I argued that futures targeting would also eliminate the need to agree on a single monetary policy instrument (or indicator if you prefer.) This is a huge advantage, as the Japanese discovered that the short term interest rate instrument was ineffective once rates hit zero. The market would choose whatever indicator they thought best. Paul might look at the fed funds rate as an indicator of Fed policy, Nick might prefer M1 or M2, and Arthur might get inspiration from the price of gold. A populist’s dream: an FOMC with 300,000,000 million potential members. And Ben could retire to one of those newly affordable condos on Miami Beach. (Affordable on a government pension thanks to . . . oh nevermind.)

The recent crisis convinced me that there is one more advantage, which may be greater than all of the others. NGDP futures targeting would eliminate uncertainty about how much credibility the Fed’s policy had in the markets, at least for as long as investors expected the policy to persist. As a practical matter, central banks are very reluctant to shift course after committing to a new policy, so I don’t think credibility would be a big problem, unless they foolishly picked a target variable that did not mesh with their true social welfare function. (This is one reason I don’t like inflation targeting, an issue I will discuss in another post.) As long as the policy was credible, the market could estimate the demand for base money under the assumption of precisely known NGDP growth expectations.

In contrast, consider the fiasco of last October. The basic problem had nothing to do with whether the market could forecast NGDP better than the Fed (although I think it did forecast better last October) but rather that the Fed wasn’t even targeting it’s own forecast. Why did the Fed not set the base at a level expected to produce on-target NGDP growth? Probably because there was enormous uncertainty about how credible such a policy would be. The easiest way to understand the Fed’s dilemma last October is to consider the widespread and simultaneous fears of deflation and hyperinflation.

People feared deflation for good reason; it was quickly becoming a reality. But they also feared hyperinflation for good reason; the base was soaring at unprecedented rates. I don’t doubt that there was some rate of base increase that would have generated the desired inflation expectations, but the Fed probably feared that a base increase that large, if successful, would raise velocity and thus we would rapidly overshoot in the other direction—toward high inflation. The root of this problem is credibility; the Fed doesn’t know how credible its inflation promises will be, and hence errs on the side of mild deflation, rather than hyperinflation. Of course the markets understood this fear, and quickly figured out that disinflation, not hyperinflation, was the real risk. Markets aren’t dumb. They sniff out Fed indecision like a schoolyard bully sensing the timidity of his next victim.

So the central banks face a particularly difficult problem when then run out of conventional ammunition. They know that some amount of QE will create inflation expectations, but they don’t know exactly how much. Even worse, they don’t know how credibly the markets would view their attempts at reflation. And the velocity of any injected base money would be highly sensitive to the expected rate of NGDP, and thus highly sensitive to the credibility of the Fed’s promise to target its forecast.

With NGDP futures targeting you don’t have that problem. The same entity that sets the monetary base (i.e. the market); also forecasts the velocity at which the base will circulate. NGDP growth expectations would have never fallen below target if the Fed had already been employing a NGDP futures targeting regime in 2008. I believe this is the great advantage of futures targeting, not the other three advantages discussed in my earlier papers. This argument has never been published, or perhaps I should say never until now—because Nick Rowe tells me to forget about journals, blogs are the new forum for research. (I suppose I could consider this blog as being a sort of journal, where I serve as author and editor, and you guys are referees.)

FAQs:

1. What about the circularity problem discussed in 1997 by Bernanke and Woodford? That problem only applies to targeting regimes where the Fed observes a private futures market; and adjust its policy instrument each time the futures price veers off target. Under this proposal the price would always be exactly on target; the information being provided isn’t so much the expected future NGDP, but rather the monetary base setting expected to produce on-target growth. Bernanke and Woodford said a system that forecast the instrument setting is not susceptible to the circularity problem.

2. If the price of NGDP contracts was always exactly equal to market expectations, why would anyone trade? To answer this question it will be helpful to describe a concept Aaron and I called “quasi-velocity,” the ratio of next year’s NGDP to this year’s base. NGDP futures traders each have to estimate quasi-velocity. Suppose in equilibrium the monetary base is $1 trillion and the target NGDP is $15.9 trillion. Then the market forecast of q-velocity would be 15.9. But only a few traders would estimate q-velocity to be precisely 15.9, which is merely the (dollar-weighted) median forecast. Those who expect actual realized velocity to be higher will buy NGDP futures contracts, and vice versa.

3. Why trade before you can observe where the market thinks the monetary base will be, as that information would be helpful to traders? I would expect some traders to wait until the last minute (as on ebay), but remember that each contract is only traded for one day. After that a new contract will be adopted. Traders could roughly estimate the monetary base by looking at the equilibrium monetary base from the previous day’s trades.

4. Isn’t this just turning monetary policy into a casino? Look how irrational investors were during the tech and housing booms! There are several responses I could make here. First, I think these bubbles were famous because they were out of the ordinary; markets are usually the best way we have of aggregating information. But let’s say I am wrong; then we could give the Fed research department some money to play with, and tell them to invest whenever the price seemed irrational, or bubble-like. If the Shillers of the world are correct this should make the futures targeting regime even more efficient, and should also provide a source of tax revenue for the Federal government.

More seriously, I don’t think market irrationality would be as worrisome as many might imagine, because I believe the biggest welfare cost of monetary instability comes not from fluctuations actual NGDP, but rather fluctuations in the expected NGDP growth path (the 1929, 1937, 2008 examples that I keep coming back to.) As long as NGDP growth expectations stay on target, then nominal wages will also be well-behaved, and any temporary fluctuations in actual AD will quickly dissipate, without producing any long lasting business cycles.

5. In another post I will address tangential issues. Economists disagree as to whether NGDP growth should be equal to total factor growth (Selgin), 3% (Woolsey) or 5% (as some wimps prefer.) There are others like Earl Thompson who insist (correctly in my view) that a nominal wage target is actually best. Most of the profession seems to prefer some sort of flexible inflation target. There are disputes about whether to target levels or rates of change. And should one target 6, 12, or 24 months out into the future? Of course any monetary regime, futures targeting or otherwise, faces all of these questions.

So here’s my claim. NGDP futures targeting would have maintained NGDP growth at the target rate right through the financial crisis. Even if the financial crisis had been every bit as bad, real GDP would have done far better had NGDP continued growing at a brisk pace. But the financial crisis would have been nowhere near as bad. Bank balance sheets all over the world were absolutely devastated by going from 5% positive to negative 2% expected NGDP growth. So although the lingering effects of the sub-prime fiasco would have continued in some housing markets, the housing slump would not have spread nationwide, and to Canada as well, the commodity and stock market declines would have been far less dramatic, the dollar would not have appreciated as dramatically in late 2008, and world trade would not have collapsed.

I’d like to thank Bill Woolsey for giving me some very useful advice, although he should not be blamed for any linger problems. (Bill often seems to understand the logic of my plan better than I do.) I should also mention that my colleague Aaron Jackson has worked with me on this idea. And finally that people like Earl Thompson, Robert Hall, David Glasner, Bill Woolsey, Kevin Dowd, Robert Hetzel and others pioneered the idea of using market expectations of economic aggregates to guide monetary policy.

“So here’s my claim. NGDP futures targeting would have maintained NGDP growth at the target rate right through the financial crisis. Even if the financial crisis had been every bit as bad, real GDP would have done far better had NGDP continued growing at a brisk pace.” – 100% correct

But: “he housing slump would not have spread nationwide” – perhaps this claim is too strong. While NGDP targeting increases the economic stability, it does not make the structural supply side issues dissapear.

“and world trade would not have collapsed.” – world trade also depends on the monetary policy of the rest of the world. Small countries cannot use the NGDP targeting regime, natural resource exporting countries do not want to use anything like NGDP targeting.

123, I am less confident about the housing claim and the world trade claim, than I am about RGDP. I noticed that the housing slump did not become nationwide until NGDP started falling, which I think is at least highly suggestive–especially since an NGDP decline would be EXPECTED to depress housing prices around the U.S. Similarly, the steep slump in worldwide aggregate demand occurred right after the fall in the U.S., even in countries that had not had a housing bubble. I don’t think that was coincidence. In some cases (China, HK) it is countries whose currencies were loosely linked to the dollar. Or that do much trade with the U.S. In other cases (Europe) is was because of subtle linkages between monetary policies. For instance, a major monetary failure in the U.S. can reduce the Wicksellian equilibrium real rate worldwide. Unless the ECB acts aggressive to cut rates, their effective monetary policy becomes much tighter. And I think it is fair to say that last October the ECB did not “act aggressive to cut rates.” They were still at 4.25% at the time.

“Each buyer must put 10% into some sort of margin account. The Fed pays interest on these margin accounts.”

“Some people draw false analogies with the TIPS market. The TIPS/conventional bond yield spread may sometimes be distorted by shifts in liquidity preference. This is a problem because TIPS are not pure inflation plays, but rather close substitutes for conventional bonds which trade in a somewhat more liquid market. NGDP futures should not be attached to any sort of bond.”

NGDP futures with 10% interest paying margin account at the FED are equivalent to T bills with 10X notional amount NGDP swaps attached. So your sentence “NGDP futures should not be attached…” contradicts your sentence “Each buyer must put 10% into some sort of margin account”, because margin account is equivalent to a T-bill.

Because margin account component of your NGDP future instrument comprises about 99% of the value of total instrument, liquidity conditions would be very important in trading it, whereas you deny that liquidity conditions are important in pricing of NGDP futures.

” Thus as a practical matter the Fed would rarely take a significant net long or short position on NGDP futures.”

After Lehman I believe there would have been a huge demand in short position in NGDP futures (especially from those who estimate that the monetary policy has lags above 1 year, and those who estimate that there is a 25% probability of undershooting 1year NGDP target, 70% probability of hiting the target and 5% probability of overshooting the target”. There is some risk that flight from real asset markets to NGDP market would increase the stress in financial markets and thus deepen the start of the crisis. That is instead of engaging in real economic activities people would use NGDP market as a “call me a Bernanke’s hellicopter hotline”. Of course the sound of arriving helicopters would shorten the crisis.

I don’t disagree with your idea of targeting NGDP futures, but as per my other comments, couldn’t the same thing be accomplished by targeting the dollar? If the Fed targeted the value of the dollar, we wouldn’t have to determine the proper target for NGDP. There’s also the advantage that a market for the dollar already exists so we don’t have to invent a new futures contract. Obviously there are some issues about what value to use (trade weighted, gold, commodity index, etc.) but those seem like easier issues to resolve than inventing an entirely new approach to monetary policy.

Where do I recommend a 0 NGDP growth rate? In fact I recommend that it grow at the real factor input growth rate. My “productivity norm” has the rate of deflation equal to minus the rate of growth of total factor productivity only–not minus the growth rate of real income. So logically it calls for nominal spending growth to offset factor input growth.

By missing this crucial point you take my stance to be more deflationary than it really is–and also more distinct from your own position. Consequently I find myself more anxious than ever to have you read my pamphlet, where you will find, among other things, a formal appendiz that spells out the relation between a productivity norm and a NGDP growth rate rule very clearly.

123, I should have been more specific. What I meant is that the liquidity of NGDP futures contracts taking short and long positions will be equal. That is very different from TIPS. TIPS can only reveal inflation expectations when compared to conventional bonds, which trade in a much more liquid market. There will be no similar problem in a NGDP futures targeting regime. You are right that I forgot that NGDP futures contracts do have some characteristics like a bond.

123#2, You certainly ask challenging questions–which is what I like. When I said the Fed would try to anticipate shifts in base demand, I mentioned trend, seasonal, and day of week, but I should have mentioned any factor that is expected to shift base demand. I foresee a policy regime where the Fed attempts to estimate base demand before each auction. They then use ordinary OMOs to get to that point, before letting the market fine tune things. I should probably add an update and cite you (and Bill Woolsey who also had that thought.)

Nevertheless, it is very possible that in highly uncertain times the Fed estimate would be far off. What then? My next suggestion is that if there is a crisis, and the Fed anticipates an unusually large and unpredictable shift in base demand, then they should up the OMO/futures ratio from 5 to 1 to something like 10 to 1, or 50 to 1, so that private investors did not have to pour too much money into the NGDP futures markets. BTW, I don’t think that even under my original 5 to 1 ratio it would be that big of a problem. The margin accounts are essentially loans to the Federal government, and would be merely a small part of the enormous national debt. They wouldn’t change the total size of that debt. (Come to think of it, maybe Ben needs to put off that retirement, there’s still plenty for the Fed to do.)

Another point I would like to make is that (for several reasons) I don’t think Lehman would have led to a large increase in base demand under my system. First, there would be no bloated demand for base money because of interest on reserves. Recall that base demand only exploded in October, after the Fed started paying interest. In addition the demand for non-interest bearing base money would be far lower if NGDP was expected to grow by 5%, rather than contract by several percent. Many people think the Lehman failure caused the economic crash last fall. This is not the case. The crash actually occurred in the first 10 days of October, when the markets were crying out for leadership from the Fed, and not getting the type of response they wanted. Once markets saw that the Fed would abandon it’s 25 year policy of roughly targeting the forecast, i.e. setting policy so that NGDP was expected to grow at a decent rate, then became very bearish. It was that turn in expectations that led to the stock crash and the liquidity trap. Under NGDP targeting expectations never would have become bearish.

Joe, No, unfortunately targeting the dollar in the foreign exchange market won’t get the job done. The dollar’s exchange rate was fixed from 1929-33. If you meant targeting the dollar but letting the rate move to offset shocks, then I am much more sympathetic, but I still think my approach is best. I have recommended that Japan use exchange rate depreciation when they got into a liquidity trap, however, so I do see the value of exchange rates in some cases.

Sorry George, I changed it. BTW, we might eventually end up even closer, because I am still thinking about Earl Thompson’s idea for a nominal wage standard, which if I am not mistaken, is a bit closer to your idea than a pure GDP rule. I’ll look at your study of the productivity norm soon–these last two months I’ve had twice as much to do as I’ve had time for. But school is now out, so I don’t have any excuses.

BTW, I should also clarify the Bill favors targeting final demand, not GDP.

Forgive my amateur status. I’ve been thinking about your idea a bit and have a simple question:

Nominal GDP can rise even when real GDP is falling considerably.

I think about the stagflation of the 1970s. The Fed at the time seemed to want to inflate their way out of the problem.
In a situation like this, the Fed is aiming to make sure that the money supply is increasing greater than real GDP is falling (m x v = p x y).
As more inflation is created, people’s expectations of inflation begin to rise, prices rise even faster, NGDP growth is much greater than 5% and suddenly 5% NGDP growth target becomes harder to hit.

This doesn’t help real GDP at all, maybe even hampers it as the society becomes a bit like Zimbabwe.

With a nominal income target, a drop in productive capacity results in lower real income and a higher price level. If the inflation resulted in people raising prices more, then the real demand for goods and services would fall. Real income would fall more, and nominal income would remain on target.

If people are willing to continually raise prices, lose sales, and cut production, then nominal income targeting will result in real output and real income falls to zero.

I don’t think that scenario is likely. The same problem would occur with a money supply rule or even a gold standard. Price level stabilization requires a monetary contraction in response to a decrease in productive capacity, but I guess no foolish “inflation expections” could develop.

If index futures convertibility was introduced, then the Meltzerites would buy contracts and the Krugmanistas would sell. If the Meltzerites bought more than the Krugmanistas sold, then the Fed would make open market sales, and base money would fall. If the Krugmanistas sold more than the Meltzerites bought, then the Fed would make open market purchases, and base monney would rise.

Aha! It’s the fixed $500/$100 ratio of OMO per NGDP future contract that gets around the circularity problem, right?

Just as a thought-experiment, suppose instead you changed your proposal so that it read: 1 basis point cut in some specified nominal interest rate per $100 NGDP futures contact? It wouldn’t work, if that nominal interest rate were non-monotonically related to NGDP futures.

1. Is NGDP the right target? I’ll put this off until later, with one exception. RGDP growth in the 1970s was close to 3%. So under 5% NGDP targeting we would have had roughly 2% inflation, or 0.65% under the specific target in this post. That doesn’t look too bad compared to what actually happened.

2. Is it harder to hit an NGDP target during a supply shock? I don’t see why. In your example you say the money supply would need to grow fast enough to offset drops in real GDP. No, that is not right. It must offset shocks to velocity, to keep P*Y growing steadily.

Bill, I agree that it would be a good way for different schools of thought to “put there money where their mouth is.” Right now the markets seem to be with Krugman. I think that back in the 1970s the monetarists were more accurate in their forecasts.

Nick, No, even if one for one there would be no circularity problem. Indeed I think the version I published may have been one for one. The reason why there is no circularity problem is the the market essentially becomes the FOMC. In a 1995 JMCB paper I proposed a system where there was a circularity problem. In that system the Fed just looked at outside futures markets, and adjusted the base (or fed funds rate) whenever forecasts moved away from target. The problem that may occur (and I emphasize “may”) is that if the policy were 100% credible, then markets would never send signals of oncoming money demand changes for the Fed to respond to. The price would never budge–anticipating corrective action from the Fed, and hence no signals would be sent. Bernanke and Woodford pointed out that what you really need is the market forecasting the right instrument setting. Ironically, in my earlier 1989 example I got it right–the market tells the Fed where to set the base. Aaron Jackson and I did a paper in Economic Inquiry (2006) that used a fed funds instrument. So it can be done. In fact there two other types of futures markets that I didn’t address in this post:

1. Aaron and I created a quasi-velocity futures market (next year’s NGDP/this year’s base), in which the Fed would tell traders that they would use the forecast in that market, plus the policy goal, to decide on the base setting. Then we did the same thing, but replaced quasi-velocity with the ratio of next period’s NGDP, and this period’s fed funds rate. And had a futures market determine that ratio.

2. In a 1997 JMCB paper I proposed contingent NGP futures markets. This is similar to contingent T-securities auctions where traders tell how many T-bills they would want to buy or sell at each possible price/yield. In my example traders were given something like 10 plausible instrument settings, and the Fed asked traders to commit to buying or selling as many NGDP futures as they wish at each possible setting. The Fed would then implement the setting that most nearly equilibrated the NGDP futures market. Again, traders would be essentially forecasting the proper instrument setting, just as Bernanke and Woodford suggested.

BTW, I just remembered that I forgot to mention Kevin Dowd, who published a good futures targeting idea in EJ (1994). I will add his name.

Thompson’s nominal wage standard–which revives the classical economists’ preference for a “labor standard of value” (an idea not to be confused with the labor _theory_ of value)–is equivalent to a “labor productivity” norm for deflation, and as such would actually involve more secular deflation than the (total factor) productivity norm I tend to favor: the latter allows for NGDP growth to offset growth in real capital as well as labor input, rather than labor input only.

So, should you find yourself moving toward Thompson’s position, you will actually pass mine along the way. I hope you’ll consider resting a spell once there!

I think if the value of the dollar were more stable we’d have fewer shocks, but I do think the value should be flexible enough to account for shocks. I also don’t think you would have to specifically use the foreign exchange market to affect the value. The Fed could (if allowed by law) use a number of markets to affect the value including gold, treasuries, tips and foreign currency bonds.

123 said:
=========================================================
“ Thus as a practical matter the Fed would rarely take a significant net long or short position on NGDP futures.”

After Lehman I believe there would have been a huge demand in short position in NGDP futures … There is some risk that flight from real asset markets to NGDP market would increase the stress in financial markets and thus deepen the start of the crisis. That is instead of engaging in real economic activities people would use NGDP market as a “call me a Bernanke’s hellicopter hotline”. Of course the sound of arriving helicopters would shorten the crisis.
———————————————————

I don’t really get this objection, or Scott’s later defense.

Why is taking a short position in NGDP futures a flight to quality? It’s actually an inherently risky position quite unlike holding a bond. You only want to do it to the extent that you want to hedge something you own that co-moves with NGDP or bet against the Fed’s credibility

The NGDP futures seems like the perfect hedging instrument to keep people invested in risky, productive activities that depend on AD not falling. Thus, I can only see this policy dampening flight to quality and not exacerbating it. What am I missing?

Scott said:
============================================================
My next suggestion is that if there is a crisis, and the Fed anticipates an unusually large and unpredictable shift in base demand, then they should up the OMO/futures ratio from 5 to 1 to something like 10 to 1, or 50 to 1, so that private investors did not have to pour too much money into the NGDP futures markets.
———————————————————

Wasn’t the whole point of your proposal to get the fed out of the prediction business? As far as I can tell the policy is basically an automatic OMO, so why would you want to substitute OMOs in other stuff for automatic OMO?

123 said
=========================================================
especially from those who estimate that the monetary policy has lags above 1 year, and those who estimate that there is a 25% probability of undershooting 1year NGDP target, 70% probability of hiting the target and 5% probability of overshooting the target
———————————————————

Why would anyone believe monetary policy had long lags under this regime? (and be willing to bet huge sums on it)

“Nick, No, even if one for one there would be no circularity problem. ”

I agree. You misunderstood me. My fault; I wasn’t clear. It’s the fact that there’s a mechanical instrument rule that get’s you out of the circularity problem. Whether it’s 1:1 or 5:1 or whatever doesn’t matter (for that issue).

“What I meant is that the liquidity of NGDP futures contracts taking short and long positions will be equal. That is very different from TIPS. TIPS can only reveal inflation expectations when compared to conventional bonds, which trade in a much more liquid market. There will be no similar problem in a NGDP futures targeting regime. You are right that I forgot that NGDP futures contracts do have some characteristics like a bond.”

What you are suggesting is that the problem with TIPS market is the lack of AntiTIPS (treasury securities that offer protection from lower inflation) and if we had AntiTips we could take the average of inflation expectations from TIPS and AntiTips markets to avoid the need for liquidity adjustments. This is all true but note that the price of both TIPS and AntiTips would be influenced by liquidity conditions.

The demand for short and long NGDP futures positions will be determined by two unrelated parameters – spread between 1 year treasury yield and Fed margin account interest rate; and NGDP forecast. In times of serious fixed income market dislocations liquidity based trading (i.e. trading based on 1year treasury – Fed margin spread) could dominate. For example if due to liquidity pressures Fed margin becomes unattractive, liquidity based could close almost all NGDP futures positions (both short and long) sending false signal to Fed.

OMO/futures ratio is an important parameter, but let’s look at Fed margin account interest rate instead. If the margin is at a fixed spread above 1 year treasury then depending on liquidity conditions there would be three trading regimes: when there are no liquidity pressures margin would be attractive enough for all market participants that now hold 1 year treasuries (almost everybody would want to switch from 1year treasuries to margin accounts at the Fed); with a medium liquidity pressures NGDP speculators would be the only holders of NGDP futures; when the liquidity crunch comes there will be flight from both long and short NGDP futures. If Fed varies the spread according to liquidity conditions we would have very interesting circular dynamics: liquidity pressures would influence Fed margin account interest rate, changes in interest rate would bring new participants into the NGDP market, new participants would influence the open market operations that affect the liquidity conditions – this cycle might be destabilizing.

George, Interestingly, the very first paper I ever published was on NGDP futures targeting in the obscure Bulletin of Economic Research in 1989. In the 1990s I published a paper on a nominal wage rule. Now I’m back on NGDP futures. I still like nominal wage rules in theory, but worry about selling the plan politically (it sounds like you are trying to screw the workers.) So I keep circling around your idea, maybe I’ll stop there someday. I should probably also think about sticking to one plan, so I don’t look indecisive. I once recall a well known economist (I forgot who) who said (sarcastically) something to the effect that Robert Hall keeps coming up with the “perfect monetary system,” unfortunately it keeps changing every year.

Joe, Yes, I see your point now; and in another post I commented that we weren’t that far apart.

Thruth, I can’t speak for 123, but I think you may be right about the hedging advantage. I sort of accepted his argument, and was rushing to defend NGDP futures on grounds that I understood well, but I do think your point makes sense.

On your second point, a greater than 1 to 1 ratio would still have the market determine the monetary base, it’s just that they could do it with fewer resources. I don’t want speculators to have to bring 10s of billions of dollars into the futures market. Research on prediction markets suggests that these markets can be very efficient with even quite small volumes. I don’t recall the details, but people like Justin Wolfers and Robin Hanson have good papers summarizing that literature.

I agree with your response to 123 on the lags issue, and plan a major post on the myth of “long and variable lags” for later in the week.

Nick, Thanks for the very nice summary on your blog, I just left a comment.

123, I’m going to have to think a bit about the bond issue, but I don’t see any obvious flaw in your inflation/anti- inflation hypothetical, so I’m guessing the first part of your comment is correct. You may well be right that my plan is essentially a bond in another name. But one part of your comment confused me:

“The demand for short and long NGDP futures positions will be determined by two unrelated parameters – spread between 1 year treasury yield and Fed margin account interest rate; and NGDP forecast. In times of serious fixed income market dislocations liquidity based trading (i.e. trading based on 1year treasury – Fed margin spread) could dominate. For example if due to liquidity pressures Fed margin becomes unattractive, liquidity based could close almost all NGDP futures positions (both short and long) sending false signal to Fed.”

Maybe I misread this, but are you arguing these liquidity issues would cause problems for my plan? If so, I don’t see how. The long and short positions both involve similar levels of liquidity. So if the entire futures market becomes less (or more) liquid, I don’t see how this biases the NGDP forecast. That’s the sense in which it is very different from the current TIPS market. Or did I misunderstand your point here?

For me the bottom line is this–can I imagine a situation where these NGDP futures will trade at a price that is quite different (say more that 200 basis points different) from the actual market expectation? And I just don’t see any financial environment where that would happen. This is because all the issues that people bring up would seem to affect the market symmetrically. The only possible exception is a huge hedging demand. But as I said, if there was a huge hedging demand, why wouldn’t such a market already exist?

Scott: I don’t think you necessarily have to choose between a NGDP (of DFD) rule and a wage (or CPI or productivity norm) rule, since (to use the terminology of Rudebusch and Svensson in Taylor’s 1999 _Monetary Policy Rules_), one can be regarded as an instrument for implementing the other. For instance, the Fed could follow a Taylor-like Instrument rule of adjusting the FFR in response to deviations of the observed growth rate of DFD from some target value, in order to implement a productivity-norm inflation (deflation) rate targetting rule.

123 said,
=============
NGDP futures with 10% interest paying margin account at the FED are equivalent to T bills with 10X notional amount NGDP swaps attached. So your sentence “NGDP futures should not be attached…” contradicts your sentence “Each buyer must put 10% into some sort of margin account”, because margin account is equivalent to a T-bill.

Because margin account component of your NGDP future instrument comprises about 99% of the value of total instrument, liquidity conditions would be very important in trading it, whereas you deny that liquidity conditions are important in pricing of NGDP futures.
————-

With daily settlement, I don’t think this is true. Under daily settlement, the contract would actually be a sequence of overnight contracts, i.e. an overnight loan + 10X tomorrow’s NGDP price. The spread between 1-year and overnight rates is irrelevant. As I recall, daily settlement is used to avoid the sort of liquidity problems you describe.

Anyway, I think any comparison with other derivatives markets is a bad one because the Fed doesn’t have a policy rule based on any of them. If the Fed makes a particular instrument a credible policy target the liquidity will come to that instrument.

“are you arguing these liquidity issues would cause problems for my plan? If so, I don’t see how. The long and short positions both involve similar levels of liquidity. So if the entire futures market becomes less (or more) liquid, I don’t see how this biases the NGDP forecast.”

Yes, liquidity issues would cause various problems. Let’s say there are X long futures outstanding, and 2X short futures outstanding. Imagine that liquidity conditions change without affecting NGDP expectations, and investors decide to liquidate half of their NGDP long and short portfolios at current prices. What we get is that liquidity based NGDP future market action influences OMOs without any NGDP-expectation related reason.

“With daily settlement, I don’t think this is true. Under daily settlement, the contract would actually be a sequence of overnight contracts, i.e. an overnight loan + 10X tomorrow’s NGDP price. The spread between 1-year and overnight rates is irrelevant. As I recall, daily settlement is used to avoid the sort of liquidity problems you describe.”

Thruth, with daily settlement the spread between regular overnight rates and Fed margin rate would become the main driver of the market..

“Why is taking a short position in NGDP futures a flight to quality? ”
Margin account at Fed has zero credit risk, and as a bonus you can choose long or short futures position that derisks your existing portfolio.

123, “with daily settlement the spread between regular overnight rates and Fed margin rate would become the main driver of the market..”

The fed margin rate would presumably be set equal to regular overnight rates, such as Fed Funds, (or maybe at a slight penalty). I can’t imagine a flight to quality scenario where Feds Funds became sufficiently inferior to margin accounts to have a noticeable impact on the NGDP futures price.

“”Why is taking a short position in NGDP futures a flight to quality? “
Margin account at Fed has zero credit risk, and as a bonus you can choose long or short futures position that derisks your existing portfolio.”

but that isn’t quite the same as a flight to quality. everyone jumping out of X (the pro-cyclical asset) and into Y (safe asset) has big liquidity effects. the NGDP futures allows more investors to stay in X and out of Y. that’s presumably an improvement on the status quo.

Why not game the system if you are long a few $billion of equities, commodities, etc. by spending a small fraction of that shorting NGDP futures and allowing the monetary base to expand to the benefit of your real portfolio?

I’m most certainly not a trader, so will just pose an outsider question. In an equity or commodity market, traders are (I think) betting on the outcome of outside events. Here, the deck seems very much stacked against them. They’re not just betting against other traders (bulls vs. bears), they are betting against the house. And, the act of betting will automatically trigger a counter-bet by the house!

Why would anyone trade in such a market? Sure, they might be 100% right that the current policy is headed in the wrong direction, but what chance do they have of staying right when the house has 12 months to correct that policy?

It’s like betting on whether a horse will complete the course in more than 5 minutes or less than 5 minutes. And if you place a $100 bet that the horse will take more than 5 minutes, the bookie moves the finish line 500 feet closer to the start. And if you place a bet that the horse will take less than 5 minutes, the bookie moves the finish line 500 feet further away from the start. (The bookie tells you in advance he is doing this).

Mark’s point: if this market is thin, so a small trade can make a big difference, a gambler who has another much bigger bet, on whether the horse will collapse before finishing, might be willing to lose money in this market by betting the horse will finish in less than 5 minutes, just to get the bookie to move the finish line further away. If this became a problem, the bookie (Fed) would need to change the rule, to make is (say) only 100 feet per $100 bet.

Scott Lawton’s point: If you place a bet now, your chances of winning the bet don’t just depend on where the finish line is now, but on where the finish line will be when betting closes, because future bets will change the position of the finish line. But then you could presumably take a future bet in the opposite direction to cover yourself, if the finish line moves too far.

George, I had thought Svensson argued that intermediate targeting was inefficient. But even if he didn’t then I will. I have a new post out today that is highly critical of the Taylor Rule. In my view you want to pick the nominal aggregate that most directly correlates with macroeconomic stability, and then directly target that aggregate. In an ideal world what would be better, stable NGDP or stable nominal wages? Whatever the answer, directly target that variable. Make a futures contract linked to expectations of the optimal variable, and turn it into your policy instrument. No intermediate targets.

Thruth, I’m not sure I follow your discussion of “daily settlements”, but then you know more about futures markets than I do. I am not worried about liquidity (for several reasons.) First, trading would be subsidized with interest on margin accounts. Much more importantly, any major deviation of expected NGDP from the target price would create a strong incentive to trade. I just wish the Fed would have let me sell NGDP futures last October–I was chomping at the bit. “If you can’t steer this ship then let me try my hands on the steering wheel.”

123, I’m not sure what you mean by traders “liquidating portfolios.” Any futures that one person doesn’t want, have to be sold to someone else. The market as a whole can’t get rid of these futures contracts. There are zero transactions costs, and we know that there is currently little hedging demand for NGDP, so I still don’t see where liquidity would play a big role.

Mark, Studies show that market manipulation is not a problem in prediction markets (Aaron Jackson mentioned some papers in a comment on another recent post here.) Second, if the Fed saw a problem with manipulation, they could trade on their own account. Third, I suppose you could limit the amount that each person bought (although in practice I don’t think this would be necessary, and don’t favor it.) Finally, I doubt any manipulation would have important macro implications. Even if you bought enough NGDP contracts to lower expected NGDP growth to 4%, all that would happen is traders would rush in the next day (drawn by high profit opportunities) and undo all your well-thought out plans.

Scott and Nick, I’ll use Nick’s horse analogy. Suppose that before the horse race, the initial line is that the horse will finish in 5 minutes. (View that as being equivalent to the monetary base setting right before trading.) Let’s also assume that there are 180 bettors, and that their forecasts for the time of completion are uniformly distributed between 4 minutes and 7 minutes (i.e. one minute apart.) Now let them start betting. If the house moves the line around until trading has reached equilibrium, then the final line should be 5 minutes and 30 seconds. At that point half of all traders will expect the horse to take longer, and half will expect it to take less time. Now of course if the Fed doesn’t exactly know the quasi-velocity forecast of each trader, it won’t work quite so perfectly. It will be a process of trial and error. Some days the Fed will end up taking a slight long or short position, but through trial and error they will tend to move the monetary base to a level where they expect the trades to be roughly equally balanced. It’s easier to explain the sort of policy I don’t want. I don’t want the Fed to set the base at a level where they could easily predict the net long or short position. Last October policy was set at a level where the Fed knew full well that if they opened up the trading window for 5% NGDP contracts, the public would have been lined up at the short window.
If you don’t like the uncertainty of not knowing the distribution of the 180 horse better forecasts, then I published another version in 1997 that eliminates that problem. In my 1997 paper I had the Fed offer a series of contingent instrument settings (it could be either the monetary base or the ff rate, but not both.) Traders would fill out a form indicating how many NGDP futures they wished to buy or sell at each potential instrument setting. Traders would be told that the Fed would implement that base setting that most closely equilibrated the net long and short position of the public, and discard the rest. This is another way of having the market forecast the appropriate instrument setting. T-bill auctions have used a similar procedure. I think it is more cumbersome than needed to get around the issue raised by Scott and Nick, but if you are especially worried about this problem, then it is a way of completely avoiding the problem of investors not knowing the eventual instrument setting when they make purchases or sales.
In practice, the bettors who expected finish times close to 4 minutes or 7 minutes would bet first. This would gradually move the “line” closer to its equilibrium, triggering ever more bets as it became clearer how other bettors were thinking. BTW, doesn’t para-mutual betting actual work like this?

Scott,
“First, trading would be subsidized with interest on margin accounts. Much more importantly, any major deviation of expected NGDP from the target price would create a strong incentive to trade.”

I think 123 was worried that if on a given day NGDP expectations are constant, but yield spreads on longer term or non-guaranteed assets are exploding (as unlikely as this is) this creates a perverse incentive to stick money in a “safe” margin account and distort the NGDP futures price. I argue that if you tie the margin account rate to the right thing (something like fed funds) then those effects will always be puny relative to the direct impact of changing NGDP expectations. i.e. you will have no more incentive to stick money in margin accounts than any other safe asset if they offer the same market determined rate of return.

“I’m not sure what you mean by traders “liquidating portfolios.” Any futures that one person doesn’t want, have to be sold to someone else. The market as a whole can’t get rid of these futures contracts.”
Well, you wrote that Fed agrees to buy and sell unlimited quantities of these contracts at the target price.

“There are zero transactions costs, and we know that there is currently little hedging demand for NGDP, so I still don’t see where liquidity would play a big role.”
Liquidity conditions determine the attractiveness of Fed margin accounts as compared to regular bonds, so liquidity conditions in the bond market would drive the inflows into the NGDP market.

” In my 1997 paper I had the Fed offer a series of contingent instrument settings (it could be either the monetary base or the ff rate, but not both.) Traders would fill out a form indicating how many NGDP futures they wished to buy or sell at each potential instrument setting. Traders would be told that the Fed would implement that base setting that most closely equilibrated the net long and short position of the public, and discard the rest.”
This scheme might work if every day the total amount of new long and short positions would fixed by varying the interest rate paid on the margin account by some kind of auction process. Another way to describe this process would be this – every day Fed has to issue a fixed amount of NGDP linked bonds and the same amount of NGDP negative linked bonds, by adjusting the policy instrument so that the implied NGDP growth is 5%.

Suppose that we are operating under Scott’s plan. Furthermore, suppose we do find ourselves with a negative full employment real interest rate. The monetary base undergoes a huge expansion and so far NGDP growth isn’t falling.

Now, is it obvious that the real rate is negative?

Suppose we reach a point where exactly half the population is 100% sure that the monetary expansion thus far is not yet sufficient and trades in the futures market, betting that NGDP growth will be way, way below target.

However, on the other side, the other half of the population is 100% sure that the monetary expansion thus far will induce a massive inflation and bets equally in the futures market that NGDP growth will be way above target.

Suppose that both sides trade in equal amounts and so actual monetary base doesn’t change. Now, those that fear a great depression will reduce discretionary spending as much as they possibly can. And that’s half the population remember.

On the other hand, those that fear hyper-inflation probably don’t increase expenditures. They just hold euros or gold.

So, with half the population reducing their demand might we end up in a recession with deficient AD? How would Scott’s plan prevent it?

(I’m switching to just my last name so there’s no overlap with the host. I should have done this starting with my first comment….)

Nick: I like the horse race analogy! I’ve never bet on the races, so maybe there’s something I’m missing. If the track owner is allowed to keep moving the finish line, where’s the incentive to place a bet? As soon as I act on my belief that the house is wrong, they’re going change course.

There is no “house” in a stock market or commodities market; doesn’t that make all the difference?

ssumner: I’m not sure how your reply addresses the incentive issue. When you get a moment, perhaps try to rephrase?

Thruth, Why does sticking money in NGDP futures margin accounts distort the price? If you don’t want to gamble, go short and long at the same time. If you do, why wouldn’t your bet improve market efficiency?

123, Same answer as to Thruth.

123#2, I’m not sure you understood the proposal. The monetary policy instrument setting is what equates the long and short positions. The interest on margin accounts is simply to get people to participate in the market.

AdamP. It wouldn’t prevent your hypothetical. But you could make the same point much easier with the following:

Suppose the median forecast is very different from the actual future NGDP. Your hypothetical assumes the median forecast (5% NGDP growth), is a poor prediction. All the other stuff is window dressing that makes it look like the median forecast might have been optimal. But the forecast is not optimal in your example. So it’s no surprise we get a recession.

I’ve never said that couldn’t happen–although I think the odds of it happening are remote. On the other hand the odds of the Fed screwing up last year are now 100%, so I’m ready to try something new.

Lawton, Unless I am mistaken, racetracks adjust the odds after people bet, but they still bet. So I don’t see the problem. People have an incentive to bet if they think their forecast will be more bullish or bearish then the market forecast at the eventual base setting. Yes, the base setting will move, but people will still bet if they forecast the eventual market setting to differ from their view of the optimal setting. Remember this occurs daily, so its not like traders won’t have a pretty good idea of where we’d end up. And if I am wrong, then just go with the 1997 plan discussed above–it does not suffer from the problem of people having to bet without knowing the final setting of the base. Another version that avoids that problem is my 2006 Economic Inquiry paper with Aaron Jackson, which has people bet on velocity.

Scott, two things. First, the point is that the recession is avoidable with an attentive central banker but unavoidable with your plan.

Second, you speak about the prediction as though the process that actual NGDP growth will follow is exogenous. The large dispersion of opinions around the median CAUSES realized NGDP growth to fall short. But your plan is supposed to stabilize AD is it not?

Maybe a better example is that there’s some correlation between having negative NGDP expectations and the incentive to hold margin (I don’t know if this makes sense). Those investors going short are also being excessively rewarded for holding margin. Then the question becomes what’s driving the demand for the contract — margin or falling NGDP expectations (obviously a bit of both, but hopefully mostly NGDP expectations)

All of this is getting far from the original point. 123 argued the contract would be heavily distorted by liquidity effects. I think that you should be able to design the contract to minimize such distortions.

Prices are not distorted (you wrote that Fed stabilizes the price). Market volumes are distorted, and you wrote that open market operations are linked to NGDP market volumes.

About 1997 scheme:
“I’m not sure you understood the proposal. The monetary policy instrument setting is what equates the long and short positions. The interest on margin accounts is simply to get people to participate in the market.”
I understood your proposal (and it is much better than the one at the beginning of this post), but you should be more specific about the interest rate on margin accounts. My proposal is that the interest rate on margin accounts should be set every day so that the total amount of money in the accounts does not change from day to day.
The situation in the TIPS market is very similar to what I’m saying – treasury sets the size of the TIPS offering, and market determines the liquidity discount (and liquidity discount the equivalent of interest rate on margin accounts in your NGDP futures scheme).

Adam, I don’t agree that forecasts would be irrational, so I don’t worry about the problem you mention. If Ratex doesn’t hold, then of course my plan has problems. If it does, traders will understand that the bearish group will spend less, and perhaps reduce velocity (which is the only way your suggestion could throw off NGDP.) And they then take that into account in their forecasts.

Thruth, I suppose anything is possible with theories about liquidity. I can’t say much more than I don’t think it would distort the price much.

123, When I say the price being distorted, I meant not equal to the optimal forecast. The nominal price is always fixed as you say, but the base can move in a way that moves the price away from the optimal forecast. Your way of describing the process is probably better, as it is the optimal forecast that actually moves, not the price, as you say.

Sorry I was confused about the 1997 plan question. So are you saying the interest rate should be adjusted to keep the volume of trading each day roughly equal? I’m fine with that, but does that have to be forecast? Is it trial and error? Do you tell people the interest rate before they place their bets? I’m still not sure I quite understand how this would be done.

Scott, I do see the mis-undestanding though. I’ll be a bit more clear.

I said: “the other half of the population is 100% sure that the monetary expansion thus far will induce a massive inflation…”

The key being “thus far”, in the example there’s already been a monetary expansion and so if the pessimistic half don’t reduce expenditures then we do get the inflation. The example is a case where one half is necessarily wrong.

The point though is more generic than the example. The decision of whether or not to reduce expenditures is inextricably linked to the decision of whether to trade the future.

If the money supply is set such that the flows balance then half the population believes that NGDP growth will fall short, thus it matters by how much they think it will fall short.

You have in mind a situation where they think it will fall short but not by too much. But what if it’s knife edged (like it appears to be right now) and those who think it will fall short believe it will fall way, way short? Then you have half the population reducing expenditure and you get recession.

In this example there are really only two possibilities, allow the inflation to take place or allow the recession to take place. Clearly accepting inflation is better, well I think so. Your plan allows the recession, a central bank can choose the inflation.

Adam, I just don’t see knife edge cases as significant. I think bell-shaped forecast distributions are what happens in the real world. My instincts tell me that if half the population is wrong, and you have a knife edge situation, that it does violate Ratex. But I won’t push that point. I’d say it at least violates the spirit of ratex. But I keep retuning to this point—there is no doubt my plan won’t work if the public forecast poorly, and I think the examples you come up with are in that broad area, and importantly are even less likely to occur than plain old straightforward bias in the entire population. So I stilll don’t think you have added a major new flaw, you are just creatively slicing and dicing all the different ways the public could set the base at the wrong level. But I still don’t see these as plausible. Finally, my ultimate fallback would be to let the Fed speculate as well, with the idea being they would offset what looked like clearly “irrational” private forecasts, but general try to use the wisdom of crowds as much as possible. That’s definitely not my number one choice, but still offers advantages over the current situation, where policy is completely unanchored. It would at least “keep the Fed honest” so to speak. Indeed, in the real world that’s probably how my policy would start out–in baby steps.

“The nominal price is always fixed as you say, but the base can move in a way that moves the price away from the optimal forecast.”
So what I am saying is that in times of severe financial stress, the volumes of margin-attractiveness based trading can overwhelm NGDP forecast based trading, shooting the monetary base in a random direction at least for a week or two. Of course, after some time NGDP forecast based trading would correct the base, but imagine the chaos in-between.

“So are you saying the interest rate should be adjusted to keep the volume of trading each day roughly equal?”
Yes, without that the system would break down when it is needed the most.

“I’m fine with that, but does that have to be forecast? Is it trial and error? Do you tell people the interest rate before they place their bets? I’m still not sure I quite understand how this would be done.”
It is an empirical question what is the best procedure. It is likely that a broad range of procedures would work, if they fail there is an option of an auction with two parameters – policy instrument rate and margin account interest rate. Fed would select the combination of these two rates that is closest to the target (stability of volume and equality of long and short positions).

123, I think I will put off an answer until I can revisit this later. I am not convinced that a monetary base shock lasting a few days would have major macroeconomic consequences. Nor is it clear that more trading would distort the base, as the extra trades might be split between long and short positions. But on the other hand I don’t feel I know enough about it to have an intelligent opinion either way. And you seem to have a pretty good understanding of futures markets. Both you and Adam have pointed out some things that could go wrong, but I’m just not sure how likely they are. I am somewhat comforted by the fact that several well known economists have looked at this idea, and not seen obvious flaws. But there’s a lot we don’t know about financial markets, so my thought is that we are likely to see NGDP futures long before we see the Fed adopt NGDP futures targeting. So we will observe these markets for a while before linking them to policy. Just imagine what would have happened last September and October if we had had an NGDP futures in operation, and the Fed was declaring the risks of inflation and recession were equally balanced as they did in September), stocks started crashing, and the NGDP futures market each day showed a big loss of monetary policy credibility. It seems to me that it would have put the Fed in the hot seat, where they should have been.

“I am not convinced that a monetary base shock lasting a few days would have major macroeconomic consequences.” In worst case there would be no major consequences compared to what we had last year. In September instead of Fed sleeping at the wheel we would have random distortions of the monetary base. In October instead of interest payments on reserves we would have interest payments on margin accounts. In best case the system would work.

“Nor is it clear that more trading would distort the base, as the extra trades might be split between long and short positions.”
If there are inflows they are likely to be split between long and short positions. If there are outflows they would be path dependent – it is likely that the same percentage of long and short positions would be liquidated, so if there are more long positions outstanding, there would be more long outflows. Bottom line is that NGDP market net volume is a noisy signal in the normal times and potentially wrong signal during financial crisis.

“we are likely to see NGDP futures long before we see the Fed adopt NGDP futures targeting. So we will observe these markets for a while before linking them to policy. ”
I am sure NGDP markets will be OK, the issue is how to link them correctly to policy.

“Just imagine what would have happened last September and October if we had had an NGDP futures in operation,…”
We have TIPS, but instead of believing their own eyes Cleveland Fed wrote this on their website:
“October 31, 2008
We have discontinued the liquidity-adjusted TIPS expected inflation estimates for the time being. The adjustment was designed for more normal liquidity premiums. We believe that the extreme rush to liquidity is affecting the accuracy of the estimates.”

123, Sorry for the slow reply. Your point about the Cleveland Fed is a very good one. The irony of this is that the reason liquidity problems were “distorting” the spread was precisely because of the economic crisis. In a crisis people may prefer the greater liquidity of conventional bonds. But this means the TIPS spread was giving the correct warning albeit for a slightly different reason. The TIPS market was signally both low inflation expectations and a rising liquidity premium on conventional bonds. This made the spread even wider than what inflation (deflation) expectations alone would have produced. But the rising liquidity premium was clearly linked to falling RGDP, so the actual yield spread was proxying something a bit closer to NGDP expectations, rather than pure inflation. And what’s wrong with that?

I’m still not convinced by your proportional outflow story. You pretty much have to assume the price doesn’t equal the market forecast to make that work. That is possible, but if true than my plan could fail for 1000 reasons, not just outflows during crises. I believe the risk premium would be small, and thus the price would be relatively close to the market forecast. What do I mean by “relatively close?” I mean compared to the huge differences between Fed targets and market forecasts during recent months.

I don’t think the risk premium on NGDP futures would change much during systemic crises, nor do I think there even would be systemic crises if NGDP targeting was in effect.

Most importantly, the Fed’s daily net short or long position would be unforecastable under my plan, and hence so would the public’s position. Each day the fed would set the base equal to the expected equilibrium, even before trading began. Thus under your net inflow/outflow argument, even the sign of the risk premium would be unforecastable from day to day. If it was plus 0.1% one day, it would still be equally likely to be plus or minus 0.1% the next day. But since actual future movements in NGDP on a daily basis are highly serially correlated, the risk premia could not be very large. Is that right? (I based this on the fact that it seems inconceivable that the public’s actual forecast of future NGDP would fluctuate sharply from day to day, merely because of random changing net long and short positions in daily futures market transactions.)

Markets that are dominated by irrational players are not efficient. Let’s assume that all NGDP market participants (except Fed) are rational. Can price deviate from the aggregate forecast of all participants for a couple of weeks or months? Yes, because Fed is following volume based strategy. When bond markets are calm you can say that NGDP trading volumes are driven by NGDP fundamentals and the actions of Fed are also driven by NGDP forecast. But when there are changes in bond markets, NGDP volumes become liquidity driven for an extended period until the total size of NGDP market adjusts to new bond market conditions, and Fed becomes dominant irrational player.

“I don’t think the risk premium on NGDP futures would change much during systemic crises…”
Failures of important financial institutions are not the only thing that could cause the change of the size of NGDP market. Changes in the shape of yield curve (flattening and steepening moves) would also have a huge impact on the size of NGDP market. At this moment changes in duration preference are refleced in the shifts of yield curve as quantities of bonds are fixed, but margin accounts have flexible size, so changes in duration preference would impact the size of NGDP market.

“Fed’s daily net short or long position would be unforecastable…” Shifts of yield curve are serially correlated, so changes in size of NGDP market would be serially correlated.

“Each day the fed would set the base equal to the expected equilibrium” This just means that until the size of NGDP market stabilizes we have a return to a discretionary monetary policy.

About Cleveland Fed – agree with everything, but in addition to liquidity premium of conventional bonds there might also be a spread related to a change in uncertainty of inflation outlook.

123, There is a serious mistake in your last point. There is no discretionary policy in the sense of the term normally used by monetary economists. The market sets the MB every day. The Fed uses discretion to try to reduce its risk by picking a starting MB position that is likely to be close to the final equilibrium. The Fed has zero discretion on the final equilibrium, that’s completely market driven. So there is no discretion in the setting of monetary policy

We may have to just agree to disagree on the liquidity issue. I agree that financial changes (yield curve, etc) could affect flows into the NGDP market. My hunch is it wouldn’t cause a large risk premium. Money would flow into both long and short positions. I think the expected NGDP growth would stay in the 4.5% to 5.5% range, but admit I can’t prove it.

When size of NGDP market is more or less stable of course Fed has no discretionary power. But when there are huge inflows or outflows, market might not be always sensitive to Fed’s actions in the morning.

Liquidity issue – could you clarify how Fed would set the interest rate on margin accounts. I think that there is only a very narrow and changing range where size of the NGDP market is stable. If a rate is a bit too high all 1year money would flow into margin accounts. If a rate is a little bit too low the market will be empty.

123, The market would only be empty if the market thought Fed policy was on course, and in that case I have no trouble with the market being empty. Remember, the Fed sets the initial course, and the traders just come in and nudge the steering wheel if necessary. I can tell you it would not have been completely empty over the last 8 months. I would have been pouring money into shorting NGDP futures, if I saw no one else enter.

I agree the rate could not be higher than one year T-bill yields. Equal or lower.

I’m a rank amateur, so forgive me if I have completely misunderstood everything and ask some dumb questions. I’ll summarize how I think I understand the market would work:

– A different futures contract each day for every trading day of the year which will ultimately make or lose money depending if I bought above or below what turns out to be the official NGDP on a particular future date. (?) So if I buy a contract on July 11, can I trade that same contract on July 20? If so, how would this contract be any different than the July 20 contract itself? If no, why would I want to be stuck with the July 11 contract for an entire year? That would make for a lot of outstanding contracts and probably a liquidity problem.

Or is the idea that the contract would pay off depending on the settle price at the end of each day? If so, how is this really a prediction market relative to the NGDP number we are supposed to be predicting? In a typical futures market, the fact that every trade can be held to term if desired keeps the prices grounded to a real event; short term scalpers create opportunities for those with a longer term horizon. If the point is to simply outguess the other guessers on a single day of action, I think the market would be nothing but a game of rock-paper-scissors and the traders would be unmotivated by what they thought of the future NGDP number.

I guess I don’t see the point–or the advantage– to why a contract should be traded for only one day. Why shouldn’t the contract be traded for the whole year?

“with daily settlement the spread between regular overnight rates and Fed margin rate would become the main driver of the market..”

Obviously I’m just a layman here trying to understand something a bit over my head — but I’ll keep flailing away anyhow: my instincts are that the lack of different time horizons for speculators would create a type of liquidity problem. For instance, if I thought the predicted NGDP was way off, I might not expect the inefficiency to be corrected quickly. Would that mean that I would want to take the same position every single day for weeks or months on end (despite overnight gaps) until I thought we were at so-to-speak fair value? If so, wouldn’t that in effect create a market in which the daily-settlements are less relevant to the trader, creating whatever liquidity problem there is that I don’t understand the daily-settlements are meant to avoid?

Rob, Good questions, the contract could continue to be traded in later days, but its price would no longer be pegged by the Fed, Thus after the first day it would have no role in implementing monetary policy.

If liquidity is a problem you could do weekly contracts. And again, the Fed would subsidize trading, so I wouldn’t expect a liquidity problem.

Regarding the “correction” issue. Monetary policy corrects such that expected GDP growth is on target, say 5%. In that case, one half of traders expect growth (and hence) velocity) to be higher than the other 50% of traders. Those that expect above average growth take a long position, and vice versa. So even after there is a “correction” there is still diversity of opinion in the market. And it is this diversity that creates the market and allows for trading.

“Trading would continue until the market reached equilibrium. This would occur when the monetary base had settled at a level where there was no longer any demand for trades.”

I don’t know about economists, but a lot of traders would have trouble accepting that any market ever reaches equilibrium. Remember that most speculators are not guessing about what a price level should be. They are trying to “guess the guesses of other guessers”. Thus most price action is a rock-paper-scissors game. Even if you had a “market about nothing” in which traders traded the value of an imaginary commodity called imagineum, action would create action.

Rob, I don’t buy Keynes’s beauty contest argument, but even Keynes only applied it to long term investments like stocks. In about 12 months there would be the hard reality of the NGDP data announcement, and the payoff on NGDP contracts. That’s no beauty contest, that’s reality. Traders would be trying to guess GDP, not other traders opinions.

you do not want the market to forcast ngdp. you want the market to forecast velocity (=ngdp divided by base). so create a future contract on velocity. the fed can then take the market forecast of v and divide it by desired ngdp to obtain M.

the fed can subsidize the contract by buying an equal amount of call and put options at strike prices that make the options worth about the same. thereby, it has no exposure in velocity, only in the expected deviation from forecast.

you can have a contract on velocity for every quarter, because ngdp is measured quarterly. For M, you take the average of the base in that quarter.

Felix, It is interesting that you mentioned velocity. Aaron Jackson and I published a paper in Economic Inquiry (2006) where we suggested setting up a velocity futures market.

The proposal in this post also has the markets implicitly forecasting velocity. It is less obvious because what the market is actually doing is setting the MB at a level expected to produce 5% NGDP growth. So by estimating the level expected to produce a given NGDP, they are implicitly estimating velocity.

If you practice full-reserve banking (loans are extracted 100% from deposits) you are unlikely to have growth. For growth would be deflationary, and deflation would discourage lending (unless you had some means of accurately indexing loan principle balances to the deflation rate). It’s unclear if full-reserve banking has ever been practiced. Prior to the Florentine Renaissance, 1. new finds of metal could have provided the needed currency expansion and 2. there wasn’t much growth to speak of, and this is taken as evidence for the point.

If you practice zero-reserve banking, you are issuing money capriciously and you will get true inflation (where currency expansion exceeds growth), which I believe is what Keynesians call “stagflation” (since they conflate currency expansion and growth… plain “inflation” is almost always the latter). It’s every bit as nasty as deflation, though again it could be remedied by indexing loan principle balances.

Therefore, banking (“monetary policy” if you work at a really big bank) is just one job: balancing reserves and loans, so that people will want loans long time, and everybody (and of course you) can get rich.

Governments have precisely nothing to do with money, except that they choose which currencies will be accepted for payment of taxes. The value of a currency is equal to the value of all assets available for trade in that currency, plus the value of its exchange utility. The latter should roughly compensate the holder for the interest lost vs. a deposit. Since a currency’s exchange utility is greater the more widely it is accepted, any region engaged in peaceful trade will sooner-or-later settle on a single currency, since one currency will somehow get a small lead that will be reinforced until it reaches monopoly status. Governments can quickly sway this process by accepting a currency for payment of taxes, since everybody has to pay taxes.

Governments also dabble in banking, which is to say they issue debt (bonds) backed by their ability to collect taxes. Private banks can hold these bonds on deposit, but they have no special status as reserves above any other deposit. The Fed may use mostly U.S. bonds to back dollars, but these dollars are created through loans and their value exceeds the value of any deposits held. They are “backed” by the asset created or work performed as a result of the loan, as you will see on any bank’s balance sheet, including the Fed’s.

The dollar has been redeemable for gold at various points, but it was never “backed” by gold 1:1. The Constitution pegged the value of the dollar to that of silver, but this does NOT mean the value of dollars in circulation couldn’t have exceeded the value of all extant silver.

The risk that demand for withdrawals will exceed reserves is the price of growth, and whether this price is paid in frequent panics or in Great Recessions, it is surely worth it.

One flaw in your NGDP futures proposal: if the Fed pays enough interest on the margin account to entice ample liquidity to the market, why wouldn’t a rational investor who has been drawn to the market by the interest payment simply hedge to a market neutral position and lock in the profit from the interest? It would be easy enough to buy and sell at the same time. Sure, you could have a rule against me doing it, but how would you keep my partner from buying every time I sell? I think this would be impossible to police. You could statistically analyze the data to see how many people were cheating, but you would likely discover that everyone was.

Rob, if the interest earned isn’t any higher than the risk free rate, would it really matter? And regardless of that, if your net position is neutral then that would have no effect on what the Fed does anyway. (Unless I am missing something). So it wouldn’t really matter.

Paul, if the interest isn’t higher than the risk free rate, how would this market attract participants? I agree if your position is neutral it would have no effect on what the Fed does, but that is the problem. The incentive of paying interest doesn’t work.

Without an incentive, it is a long shot that this market would get much liquidity. NGDP on a single day a year in the future isn’t likely to be a useful hedge for investors. It is like trying to get gamblers to bet on a single Jets-Pats game next season. Why would they bother to participate when there are many other games to bet on which they might think they have a better edge on?

I don’t know the exact numbers, but I would guess it wouldn’t be any different than the attractiveness of T-bills or any other riske free instrument. And if that isn’ the case, add 50-100 basis points then. I don’t think liquidity is the biggest problem with the idea, but I definately am not knowledgeable enough to have any valid critisims. 🙂

On a side note, I think a better analogy would be that it would be like betting on the over/under of the sum of all points scored in a whole season rather than betting on individual games over/under. Each game would contribute to the total over/under, just like each firm would contribute to NGDP.

Another problem: since the price of a single contract never changes, I can exit the market at the same price I entered–at any time–therefore I am taking no risk when I enter. So it doesn’t make sense to allow the contract to continue trading after the first day. But if you don’t allow the contract to continue trading after the first day, you force traders to hold the position for an entire year. That would make the risk on the contracts very high indeed, if one has no ability to liquidate their positions. So the risk premium would be extremely high. Scott’s observation that commodities futures contracts don’t have a risk premium isn’t relevant, because one can liquidate a commodity futures contract at any time.

The ability to exit at the price you entered also creates intra-day trading issues. All the trading up until just before market close is meaningless. The market might as well only be open for five minutes a day. Actually, with high-frequency trading now, it would only need to be open for about 5 nano-seconds.

1) The Fed adopts a constant growth target but does NOT disclose the target to the public (the public is free to speculate)
2) NGDP futures contracts work more like commodities futures contracts. There are 4 contracts per year, corresponding to the end of each quarter, and these contracts begin trading several years out. The contracts trade up until the day the quarter ends. The price of the contracts is free to float wherever it wants. Only those with outstanding contracts at the end of the quarter will need to compare the closing price with the actuals, to find out how much they won or lost.
3) The Fed discretionarily conducts OMO in order to steer the contract to the desired price.

Now, why would anyone trade such a contract if they knew the Fed was trying to manipulate the price of it?

1) Because they think they know what price the Fed will manipulate it to, and the contract is currently trading above or below that value.
2) Because they think the OMO’s won’t stabilize NGDP, despite the target, and they are instead looking at other variables.
3) Arbitrage with other markets.

Disagreement would make the market. Would it be all that different from how Fed watchers operate currently, trying to guess what the Fed is thinking and reacting to what the Fed does?Would it matter if most everyone figured out what number the Fed was targeting? No, because of 2.

But would this accomplish the goal creating long term NGDP stability expectations? The market will tell you.

Carl, The governemtn has a monopoly on the supply of currency, so they do control its value.

rob, I thought of that too. I like to look at it from the other perspective. If no one is trading (and taking a net position), the public must think monetary policy is right on target. After all, with zero transactions costs, speculators would jump in if the Fed was expected to miss its target, like late last year.

This always horrifies my supporters, but I wouldn’t even mind allowing the Fed to do a bit of discretionary OMOs on their own, as long as the market was able to offset mistakes. It’s like I wouldn’t mind letting my 10-year old daughter hold the steering wheel of a boat for a few minutes, as long as I was right there to grab the wheel the moment the boat veered off course. Did I just compare Bernanke to my 10-year old daughter?

All I really want here is a mechanism to prevent fiascos like last September-October.

rob and Patrick, You both had some good points in your debate. But rob you misunderstood one key point. Investors would not have to hold the asset for 12 or 14 months. The price would only be fixed on the first day. Each day a new contract would be created, and it would also trade at that fixed price. Only new contracts would be used to guide monetary policy. As soon as these contracts were no longer used for setting monetary policy (which is only one day in one version of my proposal) the assets could freely trade at any price. So they could get out at any time.

rob, Your 5 nano-second example is also something I thought of. Indeed I had an alternative proposal that dealt with that problem. What your example really imlpies is that I set this up in the worng way. All trades should be simultaneous, and contingent on the instrument setting. So each bidder fills out a form indicating their preferred long or short position at all plausible instrument settings (say the monetary base) Then the Fed finds the instrument setting where long and short positions in the market balance, and just executes those contracts. I published this idea in 1997. More and more people are telling me this is a better way to go, and your nanosecond example sort of implies the same.

I’m not sure about the secret target for two reasons;

1. It’s hard for big institutions to keep secrets.
2. By using OMOs to steer the market price to the target, the market would qucikly figure it out. Then you’d be back to the circularity problem. They used to do this with their fed funds target—just have the market figure it out based on the Fed’s actions, with no explicit announcement.

Carl Lumma, I don’t think you understand how governments practice monetary policy. Read “The Theory of Money and Credit” by Ludvig Von Mises. That will tell you about the early 20th century version of it. Read any more modern book to understand what it morphed into.

States mandate a “legal tender” currency that must be accepted. In that way they “control” the currency. They don’t control it absolutely if the currency they supplied was subject to wild fluctuations in it’s value then people would stop accepting it, even if the punishments for doing that were high.

The state has a set of tools that allow it to prosecute monetary policy, these ensure that money isn’t really a free market:

* Legal tender laws.
* Laws on paying taxes.
* Power over which banks are protected by the central banking system.
* Power over the reserve ratio used by banks within the central banking system.
* Power over which banks are in the deposit insurance system.
* Power to bail various organizations out.

It is with these that they construct their power over monetary policy. Despite what Post-Keynesians say this power is quite real. Scott and I can go into nerdy detail about exactly how it work if you want.

Scott you said:
“I’m not sure about the secret target for two reasons;

1. It’s hard for big institutions to keep secrets.
2. By using OMOs to steer the market price to the target, the market would qucikly figure it out. Then you’d be back to the circularity problem.”

1- I don’t think it matters whether it is kept secret or not. I simply think it’s more in the spirit of things not to announce it, but it shouldn’t matter.

2- Why is the circularity problem a problem? So the market knows what price the Fed will steer it to — so what? That wouldn’t keep people from playing it. Imagine this scenario: the price trading at exactly the target, but traders decide that the Fed will need to add money to hit that target. So the market will trade to a lower value for some period of time, before the Fed manipulates it back up. It will be incentive enough for traders to make money on that short term move. Few traders would hold their positions long, but that is fine. The Fed should probably use game theory in deciding exactly when and how much money to add/subtract, so at least their timing remains unpredictable.

But, one might say: the moment the price traded above or below the target other speculators would jump in and snap it back to the target before the Fed even reacts. However, eventually: if people felt the price was way off-target they would place a bet that it would eventually land off target. For instance, if the S&P were crashing you would short NGDP futures and buy S&P futures. So the market would be self-correcting. It wouldn’t, however, be a smooth, steady as-she-goes ride. Like every other market in the world, it will be unpredictable.

To clarify: if NGDP futures were trading at the target price and the S&P was crashing, a likely hedge trade would be to short NGDP and buy S&P. In this situation, the trader would not mind at all if the NGDP market gets manipulated to stay at its target price.

[…] on market forecasts w/o a circularity problem, but they are too radical for the Fed, as the market would essentially become the FOMC. But Svensson’s idea for targeting the Fed’s own internal forecast is eminently […]

[…] 4. To avoid the “circularity problem” identified by Bernanke/Woodford, and also Garrison/White, you’d have to let the market actually determine the setting of the monetary base most likely to produce on-target NGDP growth. I described how in this post. […]

[…] of others. And certainly no one can claim that my proposal lacks specificity—it is just as rule-based as Taylor’s famous policy rule. It also has the advantage of being forward-looking, which is a huge plus in a fast moving […]

[…] Schiller, but also by Scott Sumner for his NGDP futures. Here is Scott in what I consider to be his most detailed blog post on the idea of NGDP futures: “Note that it is not particularly important that the actual future GDP is equal to these […]

[…] I relied on information from his blog to piece together his vision of NGDP futures. In particular, I relied on a post from May of 2009 to get his basic picture of NGDP futures. Here are what I assume would be his contract specifications for NGDP futures, based on my reading […]

[…] And how about compensating each FOMC voter based on the accuracy of their vote. Let policy be set at the median vote for the instrument setting. Then pay people more who were “correct” (i.e more hawkish than average when ex post NGDP ends up above target, and vice versa.) That’s the essence of NGDP futures targeting. Of course the real world system would be more complex. I have a paper coming out soon, but until then my 2006 Contributions to Macroeconomics paper will have to suffice, or this blog post. […]

[…] good blog post on NGDP futures is Sumner’s post in 2009. I am also using his recent paper from Mercatus as a basis for these comments and […]

Leave a Reply

Name (required)

Mail (will not be published) (required)

Website

Search

About

Welcome to a new blog on the endlessly perplexing problem of monetary policy. You’ll quickly notice that I am not a natural blogger, yet I feel compelled by recent events to give it a shot. Read more...

Bio

My name is Scott Sumner and I have taught economics at Bentley University for the past 27 years. I earned a BA in economics at Wisconsin and a PhD at Chicago. My research has been in the field of monetary economics, particularly the role of the gold standard in the Great Depression. I had just begun research on the relationship between cultural values and neoliberal reforms, when I got pulled back into monetary economics by the current crisis.